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Monday, October 29, 2012

I’m going to propose a compromise between the current policy of
$40 billion bond purchases each month, and a radical policy of
immediately targeting the forecast. Have the Fed start QE3 at $40
billion per month, and then increase their purchases at a rate of 20%
each month, until they have achieved their policy goal (of equating
predicted nominal growth with desired nominal growth.)

This proposal would most likely pack a punch and raise expected nominal income growth. It would also once and for all settle the debate on the efficacy of monetary policy at the zero bound. There is no doubt in my mind what the outcome would be.

A big problem, though, with implementing so much monetary firepower is the absence of a well defined policy goal. Currently, the Fed has a vague policy goal of improved labor market conditions in a context of price stability. No one really knows what that means. Scott would like to change that by having the Fed target the NGDP forecast using NGDP futures contracts. This is a great idea as it would put monetary policy on autopilot, increase transparency, and respond to money demand shocks. But the Fed is along way from adopting such a goal.

Here is a suggestion for a less ambitious way for the Fed to target the forecast. First, the Fed would set a target for average nominal household income growth over the next year. Second, the Fed would contract with multiple polling organizations to do a weekly poll where they ask households how much they expect their dollar incomes to grow over the next year. Third, the Fed would take some average of these polls and compare it to the Fed's targeted growth rate for nominal household income. Fourth, the FOMC wold then conduct open market operations to bring household's expected dollar income growth in line with the Fed's target growth rate.

If more immediate feedback was needed, the Fed could contract to have the polls done twice a weekly. This still wouldn't give the instant feedback a NGDP futures contract would, but it would be straightforward to implement. The Thompson Reuters/University of Michigan Survey of Consumer Sentiment currently asks that question every month. So it should not be that hard for them and other polling firms like Gallup to ask the question weekly.

Question: would this proposal be susceptible to the circularity critique? If so, what could be done to fix it?

Sunday, October 28, 2012

In the ongoing debate over the causes of the slump, one group of observers sees disruptions to the financial system as an important factor. Tyler Cowen, for example, has argued that there has been a rise in the risk premium caused by a lingering shock to trust:

In short, there is a prevailing sense that we are simply not as safe,
financially speaking, as we used to be. The productive capacity of the
economy may appear largely intact, but the perceived risk is
significantly higher...The slow cure for this problem is to allow asset prices, along with
perceived wealth and trust, to return to or exceed the previous levels
over time... But the process would be cumbersome, partly because trust is
more easily destroyed than restored.

Others, like David Andolfatto and Stephen Williamson have put forth related arguments, claiming that the crisis has made the "limited commitment" problem more pronounced and reduced the financial systems ability to produced enough safe assets. In these stories, there have been real shocks to financial intermediation. The economy has slowed down, then, because of negative shocks to aggregate supply. And to the extent these shocks are long-lasting or permanent, there is nothing monetary policy can do since the real side of the economy has shrunk. It is not surprising, then, that Tyler, David, Stephen, and others who hold this view are often skeptical of Fed policies to stimulate the economy.

While I can accept that there has been some real shocks to financial intermediation, I do not see these disruptions as necessarily being permanent or unamenable to monetary policy for two reasons. First, a case can be made that the risk premium in the short run can be subject to swings not tied to long-run economic fundamentals. For example, the public might become overly-optimistic during a boom and overly-pessimistic during a bust. If left unchecked, these mood-swings might create self-fulling outcomes that last some time as shown in Roger Farmer's work. In other words, what may appear to be a permanent rise in the risk premium might actually be one of many suboptimal equilibria that could be avoided with the appropriate change in economic expectations by the public.

The figure below suggests we are in such situation now. It shows the spread between the yield on Moody's BAA bonds and 10-year treasury, one measure of the risk premium. It also shows that unlike in other post-recession periods, this risk premium remains about 100 basis points above its historical average with no sign of declining.

Surprisingly, this notion that the risk premium maybe too high now was recently noted from a different perspective by Stephen Williamson. Hecontends that the destruction of safe assets (mostly privately-produced ones) has now pushed the yields on the remaining safe assets unsustainably low:

The safe market rate of interest is now too low, relative to where it should, or could, be.

Since most safe assets are privately produced, this problem could be fixed by investors demanding more privately-produced safe assets and financial firms providing them. This is not happening, but should be according to Williamson. He does not say why, but presumably because the real economy could support more safe asset production if it were running at full potential. If so, then this could be another manifestation of Roger Farmer's self-fulfilling outcomes arising from over pessimism. This understanding implies that though the shocks to financial intermediation may be "real" in form they need not have a permanent effect if public expectations could be appropriately jolted by policy.1

The second reason I think these real financial shocks are not permanent and are amenable to monetary policy is that they ultimately matter because they create a shortage of safe assets. This problem, as I noted before, effectively amounts to an excess money demand problem once one properly accounts for all money assets. Monetary policy is very capable of addressing this excess money demand problem by better managing expectations of future nominal income growth. In particular, an ambitious NGDP level target that significantly raised expected nominal income growth should both reduce the excess demand for safe assets (because of greater nominal income certainty going forward) while at the same time catalyze financial firms into making more safe assets (because of the improved economic outlook). It should also provide the jolt needed to move the economy out of the bad equilibria. For example, imagine how the public would respond if the Fed suddenly announced Scott Sumner's recent proposal of raising their asset purchase amounts by 20% per month until some NGDP level target was hit. That would be the monetary policy equivalent of shock and awe.

Some evidence supporting this view can be seen in the figures below. They show two versions of the risk premium plotted against expected inflation from treasuries. This measure of expected inflation has been highly correlated with stock market movements since the crisis began in 2008. One way to explains this relationship is that the expected inflation series since 2008 can be seen as indicator of future nominal spending and by implication, future real economic activity given nominal rigidities (See David Glasner). It makes sense then to use it as a way to asses whether changes in economic expectations are systematically related to changes in the risk premium over this same time. Are risk premiums being drive by changes in the public's economic outlook?

The first figure shows the same risk premium measure used above, the yield on Moody's BAA minus the 10-year treasury yield. It is plotted against expected inflation created by subtracting the 10-year TIPS interest rate from the 10-year nominal treasury rate. The relationship is strong:

As a robustness check, the following figure plots the spread between the Moody's BAA and AAA yields against the same expected inflation series. Similarly strong results that indicate that an improved economic outlook drives down the spread.

Given these relationships, it stands to reason that the explicit adoption of an aggressive NGDP level target would go a long ways in returning the risk premium back to its long-run value. In the figure above that would mean returning the BAA - 10 year treasury spread to about its 2% historical average. This is just another reason why monetary policy can still pack a meaningful punch.

1This understanding also implies Stephen Williamson might be a lot closer to Mark Thoma's views on the output gap than he realizes.

Wednesday, October 24, 2012

Joe Weisenthal has a numberofpost arguing that data are showing the green shoots of a robust recovery. I hope he is right, but am leery of jumping the gun in believing a real recovery is underway. There is still a shortage of safe assets and liquidity demand remains elevated. What would really convince me that a strong recovery were underway would be a marked improvement in two forward-looking indicators. The first one is a question on the Thompson Reuters/University of Michigan Survey of Consumer Sentiment where households are asked how much their nominal family income is expected to change over the next 12 months. The figure below average response for this question up through February, 2012.

This figure shows that during the Great Moderation period (1983-2007) households expected their dollar incomes to grow about 5.3% a year. This relative stability of expected nominal income growth is a testament to the success of monetary policy during this time. However, since 2008 households have expected 1.6% dollar income growth on average. Until this changes, there is no way a recovery will take hold. And yes, this speaks poorly of Fed policy since 2008. (My access to this data is limited by a 6-month lag. So if you have access to this data, please let me know the latest numbers.)

The second indicator is simply the 10-year treasury yield. As I noted many times before, this interest rate is currently at historic lows largely because of the weak economy, not the Fed (i.e. the short-run natural interest rate is depressed due to an increase in desired savings and/or a decrease in desired investment). If the economic outlook were to improve, then the 10-year yield would go up because of higher expected real growth as well as some higher expected inflation. And yes, the Fed could do more here by raising expectations of future nominal income growth. An explicit nominal GDP target should do the trick:

So until these two forward-looking indicators meaningfully turn around, I will remain hopeful but uncertain about our recovery.

Sorry for the blogging hiatus. I have been busy with other projects--I am seeking tenure after all and have to produce research that counts toward that goal--and activities. Some of these activities have been several trips to Capital Hill to do briefings on nominal GDP targeting to Congressional and Senate staffers. One of those trips was yesterday, with Scott Sumner and I presenting to a group of about 70 staffers. Former Dallas Fed President Bob McTeer moderated. Here are the slides I used in my talk and here is Scott's new paper on NGDP targeting. We had a good time and hopefully changed some thinking on the Hill. Thanks to John C. Goodman and the NCPA for making this happen.

PS. Too bad Bob McTeer is not still the Dallas Fed President. He is a great monetary economist. Be sure to check out his blog.

Friday, October 5, 2012

Gavyn Davies has a new column
where he responds to Michael Woodford's call for a NGDP level target.
Davies is always a good read, but this time he raises some concerns
about NGDP level targeting that are unwarranted. He claims that the
Fed may be uncomfortable with a NGDP level target because it might
unmoor inflation expectations, it might be seen as time-inconsistent
with the Fed's long-run objectives, and finally it may be too late to
return NGDP to its pre-crisis trend. While understandable, the first
two concerns are without merit under NGDP level targeting. This
approach to monetary policy actually anchors long-run inflation
expectations and provides a credible way to commit. The last concern
has more merit, but even here it is not a clear-cut case. Let's look at
each of these concerns in turn.

Caroline Baum says yes. She is referring to the 2002 speech where Fed Chairman Ben Benarnke told Milton Friedman that the Fed would not make the same mistake it did during the Great Depression. The only problem, though, is that Bernanke saw the Great Depression more from a financial crisis perspective than a shortage of money (i.e. excess money demand) perspective. Consequently, he approached the 2008-2009 crisis from that perspective. Baum notes he focused so intently on saving the financial system that he lost sight of the excess money demand problem. In terms of the equation of exchange, Bernanke was so concerned about the collapse in the money multiplier (or financial intermediation) that he failed to prevent the decline in velocity. As a result, aggregate nominal spending experienced its sharpest decline since the Great Depression. So to some degree, Bernanke did repeat the mistakes of the Great Depression.

Baum also has this to say:

The similarities don’t end there. During both the Great Depression and the 2007-2009 recession, policy makers viewed low interest rates as a sign of easy policy. The same goes for the high level of excess reserves, the deposits banks hold at the central bank over and above what is required. The Fed unwittingly aborted the mid-1930s economic recovery when it raised reserve requirements in 1936-1937 to absorb the excess reserves banks were holding as a precaution against bank runs, according to Friedman and Schwartz.

What did the banks do in response? They cut lending so they could rebuild their excess reserves to desired levels.

Lesson learned? Apparently not. Fast forward seven decades, and the Fed started paying interest on excess reserves, “increasing the incentive for banks to hold more excess reserves, just as it did in 1936-1937,” says David Beckworth, an assistant professor at Western Kentucky University in Bowling Green, Kentucky.

He said that in a blog post in October 2008. Beckworth is part of a group of market monetarists who advocate a nominal gross domestic product target for the Fed. Nominal GDP plummeted in 2008-2009. And in the last four years it has grown at the slowest pace since the Great Depression.New Assessment

It has taken your humble correspondent a few more years than Beckworth to come around to the view that the Fed isn’t running a recklessly easy policy. As I said in an Aug. 1 column, I have started to rethink monetary policy, partly in response to the results it has produced (lousy) and partly in response to recent research (provocative). Because the economy is stuck at sub-2 percent growth, and because the only bang from fiscal policy comes from monetary policy -- unless the Fed monetizes the spending, it’s just a transfer of resources -- the Fed must bear primary responsibility.

Exactly. The Fed has effectively kept monetary policy tight over the past four years. We call this a passive tightening of monetary policy.

Let me also note that while I believed the adopting of IOER in late 2008 tightened money policy and probably helped push the economy over the cliff, lowering it today may not have the opposite effect for reasons laid out here. Also, in fairness to Bernanke and the Fed, I was actually critical of the Fed for being too easy in 2007 and most of 2008. I though the Fed was pandering to Wall Street and the Jim Cramers of the world. In retrospect, I was wrong and only gradually began to change my views in late 2008. So I should not be too hard on the FOMC for its stance of monetary policy through late 2008, even though in hindsight it was too tight. I suspect Scott Sumner had it right all along.

Thursday, October 4, 2012

The Wall Street Journal reports on the protests sweeping through Tehran:

Protests over the plunging Iranian currency erupted on Wednesday around Tehran's main bazaar, the country's commercial hub, as escalating economic woes become a rising political challenge.

The demonstrations marked the first time in three decades that the conservative merchant classes, a backbone of the Islamic Revolution in 1979, have publicly turned against the government.

Steve Hanke shows that the currency plunge is closely tied to the imposition of sanctions and that the extent of the plunge amounts to a new case of hyperinflation:

When President Obama signed the Comprehensive Iran Sanctions, Accountability, and Divestment Act, in July 2010, the official Iranian rial-U.S. dollar exchange rate was very close to the black-market rate. But, as the accompanying chart shows, the official and black-market rates have increasingly diverged since July 2010. This decline began to accelerate last month, when Iranians witnessed a dramatic 9.65% drop in the value of the rial, over the course of a single weekend (8-10 September 2012). The free-fall has continued since then. On 2 October 2012, the black-market exchange rate reached 35,000 IRR/USD – a rate which reflects a 65% decline in the rial, relative to the U.S. dollar.

Move over Zimbabwe, Iran is the new poster child of hyperinflation.

Question: was this hyperinflation part of some grand plan coming out of the CIA/Defense Department/State Department? Did economists in these institutions foresee that the sanctions would eventually push the state into creating a hyperinflationary environment? Was it part of the plan?

Tuesday, October 2, 2012

1. I owe Fed chairman Ben Bernanke an apology. Based on David Wessel's book, Larry Ball's paper, and the inconsistencies between Bernanke's old and new work, I was convinced that Bernanke was being too nice of a guy at the Fed. Jon Hilsenrath, however, shows in a recent piece that I was wrong. Bernanke, in his own way, manned up and convinced the FOMC to do QE3. Yes, a few years too late and not quite a a NGDP level target, but it is a start. Bernanke now needs to finish his job by convincing the FOMC to now adopt a NGDP level target. See Matt O'Brien for more on how Bernanke transformed the FOMC.

2. Matt Yglesias reminds us that the Reserve Bank of Australia is probably the best central bank in the world. Australia has not had a recession in over 20 years, an outcome Yglesias attributes to sound monetary policy. A related question that has vexed me is how Australia has been able to run almost 60 years of current account deficits. Josh Hendrickson thinks that given the relatively stable macroeconomic environment in Australia, foreigner investors have come to view the Australian dollar as a reserve currency of sorts and are glad to hold Aussie assets. What do you think?

3. Apparently many observers, like CNBC's Rick Santelli, were upset that Ben Bernanke claimed in a recent Q&A that Milton Friedman would endorse his views. Joe Weisenthal reports:

[Bernanke] pointed out that Friedman advocated QE for Japan during its struggle against deflation and weak growth. He also recalled one of Friedman's most important lessons, that low interest rates...Bernanke said specifically, when citing the lesson of Milton Friedman: "We didn't allow the fact that interest rates were very low to fool us into thinking that monetary policy was accommodative enough."

As I have noted before, Milton Friedman probably would have advocated systematic, rules-based polices that would have restored aggregate nominal income to its pre-crisis path.

4. Andy Harless explains that the Fed is the one institution that could meaningfully respond to the worst case outcome for the fiscal cliff:

[I]t’s hard to think of any feasible monetary policy action that would both be strong enough and have a sufficiently quick impact to offset the fiscal cliff directly. But what matters more for monetary policy is not the direct effect but the effect on expectations. Surely the Fed could alter expectations of future monetary policy in such a way that the resulting increase in private spending would be enough to offset the decreased spending due to fiscal tightening.

He goes on to argue that the Fed adopting a NGDP level target that aims to put nominal spending back on its pre-crisis path would be just such a policy. However, he is not hopeful it will happen. Scott Sumner agrees. This discussion highlights the Fed's ability to offset adverse fiscal policy shocks. It is also highlights why it is hard to measure the size of the fiscal policy multiplier if the Fed is offsetting such fiscal policy shocks. However, if Harless is correct, we will have a natural experiment of sorts later this year that will allow us to get a better glimpse of the size of the fiscal policy multiplier.